The Subjective Function (Part 2)

My last post (http://www.optionfanatic.com/2012/10/05/the-subjective-function-part-1) defined the subjective function.  Today I want to present another perspective on the subjective function by explaining what I previously missed.

The gist of my previous posts is that all traders are looking for the same general thing.  “Consistent profitability over time” is a phrase I have written many times over.  Yes, Trader A may be looking for the supercharged exponential returns that carry the risk of heavy drawdowns while Trader B is more conservative and will sacrifice returns to minimize drawdown.  Aren’t they both basically looking for consistent profitability over time, though?

No.

I now see that Trader A and Trader B are looking for decisively different things.  My “consistent profitability over time” is what Trader B seeks.  Trader A, however, is in effect buying a lottery ticket and hoping for the big payout.  If financially savvy then Trader A is playing this with a limited percentage of the total portfolio so as not to go completely bankrupt.  Trader B might be all-in with proper asset allocation.

My previous lack of understanding might reflect an inadequacy of language itself.  I suspect we just don’t have enough terms to reflect the variety of individual preference for investment returns.  Compound annual growth rate (CAGR), drawdown (DD), and flat times translate directly to features seen on equity curves but others do not (e.g. profit factor, Sharpe and Sortino ratios).  Equity curves reflecting the same CAGR or DD can look wildly dissimilar, however.  The pictures tell more than words can describe.

Moving beyond language in this manner is what Dr. Bandy recommends in Quantitative Trading Systems (2007) to determine the subjective function.  After running the trading system optimization, scroll through the different equity curves to find the ones you like best.  Note which metrics score highest on your favorite equity curves and voila!  You have the subjective function.  This is not unlike a visit to the eye doctor where you endure an exhausive series of “which lens is better:  one or two?  1 or 2?  2, or 1?  2, 1?”

In fact, let’s do that:  a visit to the optometrist’s office, and more, when we return.